January’17 Financial and Banking Features Newsletter

Summary

How will Central Banks cope with 2017 shocks? Perhaps new rules, one-off solutions, doubtless lots more QE. Populism will perhaps be their saviour.

Mainstream media are worried about 2017 shocks. So they should be. If you had gambled a pound (or euro) this time last year on a triple accumulator; Leicester City to be English football champions, Brexit, and then Trump, you would have redeemed your betting slip for a million. Bookmakers are not offering odds anywhere like that on a ‘quad’ bet now popular; i) Geert Wilders (Netherlands, March 15th), presently polling at 20%, ii) Marine Le Pen, (France, April 23rd[1]), 25%; iii) Frauke Petry and Jorg Meuthen (Germany, August 27th[2]), 13.5%; iv) Beppe Grillo of 5 Star (Italy, date uncertain, perhaps October), 28%. Your authors, despite reduced odds, fancy a little flutter.

For the ECB and Bank of England, already struggling with separate credibility problems discussed below, any such shocks might prove rather welcome. How so, you may ask, given that they lobbied for ‘Remain’ and obviously would have been delighted with Clinton?

Since quelling Bundesbank objections to QE at end 2014, the ECB has had a free run to apply whatever monetary policies it likes. However, unemployment levels (although declining for several quarters) are still worrying, and sections of Europe’s banking system do not feel particularly safe. However, many hedge funds and other highly leveraged investors have had another decent year making fairly obvious bets on the increasingly predictable policy responses to various events (Brexit and Trump, perhaps not Leicester City). The ECB has always had one eye on protecting its reputation.

Since the first of the sovereign bailouts (Greece, 2010) it pushed hard at first for ‘structural reforms’ from national parliaments. When ‘austerity’, the term’s synonym, became a dirty word (2012/13) the ECB changed tactics and strove for banking union. Now that Germany has blocked that (no chance of any common deposit fund) the ECB has flipped back onto its structural reform hobby horse. But its calls fall on deaf ears. In November, ECB board member Benoit Coeure appeared to worry about the future of the euro itself[3]:

“even in a fiat money system impaired creditworthiness of governments ultimately creates the risk of an eroding trust in the ultimate safe asset: central bank money”

However, the ECB’s credibility problem is modest compared to the Bank of England’s. A recent book “All Out War” by Tim Shipman, political editor of The Sunday Times,[4] records that the stakes on both sides of the Brexit battle were so high that the Geneva Convention was almost breached, despite of course the veneer of politeness being meticulously observed by all actors at all times. Patrick Minford played a small but significant late part. Many had been sceptical when the Bank of England’s ‘gravity model’ based forecasts for a Brexit sparked recession were published. Minford knew these were not only wrong but carefully constructed ‘fixed’ models intended to influence the referendum. He formed a group of only perhaps ten economists who called themselves “Economists for Brexit”, and enjoyed substantial airtime. Now, more than six months later, the modelling is discredited and Carney has faced resignation calls, the charge not being any lack of competence, but of breaching the political neutrality of the Bank. Early in January Haldane, the former head of Financial Supervision, gave a speech at which he conceded that the Bank of England is incompetent at making economic forecasts. Even worse than its Brexit forecasts, Haldane emphasised, was the Bank of England’s failure to spot any signs of problems in the banking system on 2007, even after the failure of Northern Rock. Given his present role as Chief Economist, the media headlined as if Haldane was playing the mea culpa card. Given the pressure facing Carney, and the public put down suffered by Haldane in 2013 for criticising Basel risk weighted asset measurements of bank solvency, it is perhaps also a careerist move, the subtext being ‘my boss made me do it’.

Less well reported, but a far more serious threat to the Bank’s already damaged credibility are its actions concerning British banks’ minimal regulatory capital buffers immediately after the referendum. This point does bring incompetence into play. As we reported given the choppy waters into which the UK economy was headed, the Bank decided to reduce each bank’s capital hurdle by 0.5%. It reset to zero the Countercyclical Capital Buffer or CCyB[5]. The actual text:
“The [Bank] was concerned that banks could respond to these developments by hoarding capital and restricting lending. The reduction of the CCyB rate was intended to reinforce the FPC’s expectation that all elements of capital and liquidity buffers are able to be drawn on to support the real economy.”

There is a serious problem here, the Bank seems to have applied the CCyB the wrong way round. As Kevin Dowd has recently explained:

“The purpose of the CCyB is to counter the financial cycle: as aggregate credit builds, markets boom and risks build up; then the boom breaks, markets fall and the risks are realised and subsequently fall. The CCyB should rise in the first phase to help slow the euphoria, and then fall in the second phase to ameliorate the distress.”

If the problems the Bank feared were in the future, the July decision should have been to increase the CCyB. The only justification for lowering it would have been if the UK was already in phase two (a recession) in June 2016. Given that it wasn’t and isn’t now, and furthermore that the Bank of England is far less worried about the outlook, it should immediately increase the CCyB’s of each bank.

The only possible reason for not so doing is the fear that this would expose capital shortfalls in UK banks. This reason makes sense to us. It would also explain why these two powerful central banks lobbied feverishly against Brexit. The banking system is strained now so near its breaking point, they feared that even a ripple in the millpond might trigger Niagara Falls. For the ECB and Bank of England one or more of the four shocks might be rather welcome. There is nothing like a new crisis to encourage the media to move on from the last one.

A most interesting point concerning the nationalisation of MPS which even the mainstream picked up is that no sooner had the decision to nationalise taken place than the amount of capital needed to recapitalise the bank jumped from €5 to €8.8 billion euros. How did that happen? Did somebody fail to add up correctly? No. Quite simply BMPS could not manage to structure and sell its mooted €28bn NPL securitisation in time, which would have made it look less insolvent. It will also raise €15.8 billion debt, which the government will guarantee, in order to “restore liquidity and boost investor confidence”[7]. Quite how loading debt onto an insolvent rump of a failed bank will improve confidence is beyond us.

The new debt will allow MPS time to securitise these €28bn of NPLs, following the template established by Banca Popolare di Bari (BPB). We explained before that BPB was able to restore its regulatory solvency with this NPL trade. Recently we have spotted two features of the BPB model which will encourage MPS to follow suit:.

i) Although the only market participant in the structure, the mezzanine (B bond) buyer, ranks junior in a de jure sense to the senior note (A Bond), the structure is so cleverly designed, the coupon differential between A and B bond so wide, that de facto the B bond ranks superior to the A . We expect the B bond holder to receive more than twice the total cashflow paid to the A holder, despite the B note being smaller than the A by a ratio of 10:85.
ii) Although NPL asset backed securities are expressly excluded from the ECB bond buying program (QE), these securities are eligible as collateral for ECB repo liquidity funding provided that the second-best rating is at least single A. This prevented BPB’s notes (rated only Baa1) being identified on the published list maintained by the ECB of eligible collateral, and has to date kept the lid on the Italian Treasury’s ingenious scheme to transfer the NPL problem onto the printing press of the ECB. However, Unicredit and others will surely qualify given that their NPLs are reportedly less toxic than BPB’s[8].

It appears that BP Bari was a carefully selected stalking horse (if that is the right term). Its assets are so bad, so many loans in the South, that the A note rating was only Baa1. BPB’s NPL bonds cannot be exchanged with the ECB for new cash. However, the London cognoscenti expect both MPS’ and Unicredit to achieve single A ratings of their NPL securitisation senior bonds.

Bundesbank President Jens Weidmann warned his Italian counterparts in December not to rush the bailout of MPS because it might not be “sustainable” - a polite term for doubting the ability to produce a business plan for solvency. This may have been harsh, but we think fair. But the advice was ignored.

For 2017 we foresee more broken rules, more retreat from bail-in, more fudges. Unless and until someone with sufficient authority in Germany works out that Italy is at present ahead in this little chess game, Germany is about to get outflanked by Italy’s Sicilian defence.